The first era of the internet upended information industries like news, advertising and television. The second era of the internet, enabled by blockchain (the technology behind bitcoin) and other digital assets, will make those changes look quaint. Financial services, foundational to all industry, enterprise, and human economic activity, is about to change.
Bitcoin aside, a lesser known but insurgent group of projects and protocols, collectively known as decentralized finance or DeFi, is generating new digital tools, marketplaces and asset classes that have the potential to disrupt banking and much else. In one year the DeFi industry’s market capitalization has ballooned 30 times to US$73 billion, while the total value of user deposits (known in the industry as total value locked or TVL) has surged 100 times to nearly US 100 billion. What is driving this growth?
Traditionally, institutions like banks, brokerages, stock exchanges, custodians, clearinghouses and other intermediaries established trust in transactions and performed other essential functions in the economy such as moving, storing and lending money. These institutions have noticeable drawbacks: They charge high fees and add time and friction to transactions. And, because of their cost structures, they exclude more than one billion unbanked people from the global financial system. This is changing, thanks to blockchain, the technology behind bitcoin. Blockchains are tamper-resistant ledgers of transactions distributed across a network maintained by many parties. These shared ledgers serve as common sources of the truth. In effect, they supplant the records of banks and other traditional institutions.
Bitcoin enabled individuals to move value online peer to peer, without a trusted intermediary like a bank. DeFi builds on that concept, by enabling peer-to-peer models for lending, trading, investing, insurance and more, built on top of distributed networks, not corporations. These innovations are possible, thanks to a breakthrough called a smart contract — essentially a self-executing and immutable agreement settled on a blockchain, often the Ethereum blockchain (Canada’s most successful startup ever). Contracts are the foundation of every asset class, every corporation, and all economic activity. Yet, most of today’s contracts are in fact quite “dumb.”
To be clear, this is much bigger than financial technology or fintech. Most fintech innovation is digital wallpaper — a sleek user interface that conceals the old system beneath. DeFi is a new financial architecture. In fewer than two years, many of these protocols — they aren’t ‘startups’ in the traditional sense — are competing with or eclipsing many fintech darlings. Banking incumbents are surely next. The decentralized exchange Uniswap, for example, has had many days where its volumes exceeded those on Coinbase, a US$50 billion NYSE-listed company. The automated investment aggregator YFI (pronounce Wi-Fi), through which investors pool capital into a smart contract that makes investments on their behalf, hit a total value locked of US$4.7 billion within its first year. By contrast, WealthSimple took more than six years to reach the same level. DAI, a decentralized stablecoin (i.e., a digital asset pegged to the dollar) does around US$500 million a day in volume, which is more than Venmo, a popular payment app in the United States. In the second quarter of 2021, the Ethereum network settled US$2.5 trillion in transactions, up 1,500 per cent year over year, driven primarily by DeFi and stablecoins.
Except for a few publicly listed firms, this industry is largely crypto-native — accessible only online through blockchain-based applications. As such, most financial market participants are unaware of DeFi. This will surely change soon.
Financial services is more than an industry — it is the cardiovascular system of the global economy, the lifeline of all other industries. DeFi is reimagining its anatomy and physiology from banking and trading to risk management and more. This system performs nine essential functions that DeFi projects are taking on, and every company in the industry today should be monitoring these vital signs:
- Storing value: Smart contract wallets such as Parity Wallet, Argent, and Gnosis Safe could hold assets instead of bank accounts.
- Moving value: Stablecoins such as USDC and MakerDAO’s DAI route around banks, SWIFT, and other interbank settlement systems.
- Lending value: Pooled lending such as Compound and AAVE augment savings accounts at banks and other financial intermediaries and have better yields to boot.
- Funding and investing: Investment aggregators such as YFI and Rari could ultimately disintermediate investment advisers, mutual funds, exchange traded funds and robo-advisers.
- Exchanging value: Decentralized exchanges such as Uniswap, Sushiswap, and QuickSwap could replace or enhance stock exchanges and centralized cryptoasset exchanges.
- Insuring value and managing risk (i.e., derivatives): On-chain insurance such as NexusMutual and derivatives platforms such as SX, Perpetual protocol, and dYdX could supplement or replace insurance policies and over-the-counter derivatives.
- Analyzing value: Contract auditors such as Zeppelin and DeFi Score could augment or perhaps even perform the work of the Big Five accounting firms.
- Accounting for value: Block explorers such as Etherscan and PolygonScan track asset movements in real time; perhaps eventually eliminating periodic audits by accounting firms.
- Authenticating identity: Pseudonymous identities or native digital identity systems such as Shyft would provide easier access to a wider range of financial services than what financial intermediaries do today.
To be sure, DeFi has its fair share of issues. Many of these applications are built on Ethereum, a network overloaded by the popularity of DeFi. Many apps have clunky user interfaces. And let’s not overstate their popularity: Uniswap has only some two million users. Moreover, regulators have questioned how decentralized some of these platforms truly are. These are important implementation challenges to overcome. The winners will be those who overcome them.
If bitcoin was the spark for the financial services revolution, then DeFi is the accelerant. The fire spreading will engulf many firms that fail to innovate, adapt, and embrace this hot new industry. The financial phoenix that rises will be virtually unrecognizable from the system as we know it today.
Alex Tapscott is managing director of the Ninepoint Digital Assets Group (a division of Ninepoint Partners LP) and co-author of Blockchain Revolution. This article is for information purposes only and should not be relied upon as investment advice. The author or his employer may have investments in some of the companies mentioned.
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